Followers of the FIRE lifestyle will have heard of the 4% safe withdrawal rate and will be aiming to build an investment pot using this rule that’s large enough to provide them an income when they’ve retired.
The problem with the 4% rule is that it lulls us freedom fighters into the false sense of security that following a simple formula will guarantee us a set level of income in retirement.
But because your freedom fund contains a range of investments, the value of your pot will be volatile. What is worth £500,000 today could be worth £400,000 tomorrow. Or £600,000. You just don’t know.
The first 5 years of your FIRE retirement are what we call the Early Retirement Danger Zone. You have no state pension to fall back on because you’re too young, so you need your investments to perform.
But what if they don’t? What if there’s a market downturn? Using the S&P 500 Index as a measure, there have been 16 bear markets since 1926, averaging once every six years.
Today we’re going to tell you how to hack the 4% rule, force it to work for you, and make sure you can safely retire early while holding onto your money forever!
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The 4% Rule And The Problem Of Retiring Early
As a brief recap, the 4% rule says you can withdraw 4% per year of the value of your retirement pot on retirement day, adjusted each year thereafter for inflation.
The origins of the 4% rule started with the famous Trinity study, which backtested the performance of retirement portfolios built from a range of different stock and bond mixes and withdrawal rates covering the period from 1925 to 1995.
The stock market studied was America’s S&P 500, and it was determined that portfolios built from 100% stocks or a 75/25 stocks to bonds split had around a 95% chance of surviving for 30 years.
The study was set up to provide answers for people retiring in their 60s, hence why a 30-year portfolio survival period was chosen.
Unfortunately, this implies that those retiring earlier are at risk of running out of money during their retirements.
With a 95% success rate, this means 5% of people should expect their freedom funds to run down to zero within 30 years of their FIRE date, based on the history.
Here’s a chart that shows the results of a 100% stocks portfolio with starting dates in each of the years from 1871 to 1989:
6 out of 119 tests resulted in going bust. But even if you DON’T run out of money after 30 years, you still might easily end up in the 24% of people whose portfolios’ values were down – people who wouldn’t be able to keep withdrawing enough to live on without eventually depleting their investment pot.
In almost all cases, the damage was done in the initial years, and whether a pot survived its owner or not came down to the events immediately following the retirement date.
The greatest risk to your portfolio comes in the first 5 years or so after retirement.
This is because if the stock market were to fall in those early years, it would likely reduce your pot to below the level at which you could safely continue to draw from it at the same rate. Even when the stock market recovery eventually comes, your pot may be too far gone to recover while also sustaining your withdrawals.
While for example, if your first stock market crash came a decade after retirement, you would have built up a 10-year buffer of growth that could happily be eaten up by a future bear market without your withdrawals being affected.
This risk is known as Sequence Risk, and it is the risk of the good times and the bad times happening in the wrong order, or the wrong “sequence”.
According to AJ Bell, the average time it takes for the stock market to recover based on the last 10 bear markets prior to covid was 648 days – nearly 2 years.
The shortest recovery in history was the covid crash, which lasted only 4 months.
While the longest was 1,529 days – just over 4 years – following the 2008 financial crisis.
If you can set a plan in place to protect yourself for the first 5 years of retirement without needing to eat into your pot, this would nip the sequence risk in the bud.
You’d be covered for repeats of the historic worst-case scenarios, plus a bit extra. Get past this opening phase of your retirement, and you should be into clear waters.
Your FIRE Number
First, you need to know your FIRE number. This is calculated as your required living expenses in retirement divided by 4%, if you are using the standard safe withdrawal rate.
You can calculate this easily and get more information including the years until you can retire by using our free FIRE Calculator.
Try playing with it to see the effect of tweaking the rate of return on your investments, or by cutting your expenses a little, or adopting a higher or lower withdrawal rate. The difference will likely shave years off your working life.
The FIRE number is the size that your savings and investments need to be before you can retire. The usual assumption amongst those seeking early retirement is that this number, once reached, is set in stone.
But what if the stock market falls the day after you reach your number and quit your job, and what was once a £1m pot is suddenly worth only £700,000?
You’ve stopped working to start living. Do you have to change your plans and forget about retirement? Stop living and start working?
Protecting Your Nest Egg
The 4% rule can be adapted to protect your financial freedom fund in those first years of retirement, in case the market goes south right after you’ve told your boss that they’re fired.
We just need to add on one or two extra rules into the mix.
Both of these rules are fairly common sense, but the first time we saw them named and singled out for discussion was in Kristy Shen’s book “Quit Like A Millionaire”, so due credit to her.
Rule #1 – The Cash Cushion
The very worst thing you can do in a stock market crash is sell. And yet, as a retiree living off your investments, you may have little choice but to do exactly this.
This is where the cash cushion comes in.
Say your FIRE number is £1,000,000 – the amount you’d need to retire, covering your outgoings of £40,000 a year at the 4% rule.
You need to be able to avoid selling investments for up to 5 years.
To cover your outgoings during this time, having a cash cushion of £200,000 would mean you could eat this up first without ever having to touch your investments.
£200,000 sounds like a lot of extra cash to have to build up. But hold up. A balanced portfolio might already include cash in the region of 10%, so you can splurge on opportunities, but also to cover you in scary situations exactly like this.
So, a £1,000,000 freedom fund might already contain £100,000 of cash, meaning you need to find just another £100,000 to cushion you in your early retirement years.
As a counterpoint, it’s worth noting that if you did save up an extra £100k before you retired, you could invest it instead, and it would reduce your required withdrawal rate from 4% to a safer 3.6%. But it’s not clear that this would be safe enough if you were making withdrawals during an initial market crash.
In any case, while you’re building your pot, it probably makes sense to keep that extra money invested in the stock market so it can grow, rather than being held as cash, and convert it into your cash cushion just before you retire.
Rule #2 – The Yield Shield
Still, having to increase a freedom fund by £100,000 seems like a lot of extra hardship. We can get this number down significantly if we build a yield shield.
The yield shield brings in dividend stocks to your portfolio to give you extra protection in the first 5 danger years, after which point you can switch back to your preferred allocations.
Stock market returns are a combination of capital growth plus dividends. Stocks which are likely to provide decent capital growth but little dividends are called growth stocks. Stocks which provide little capital growth but good dividends are called dividend stocks.
The theory is that dividend stocks can better hold their value during a downturn due to being stable, established companies, and in most cases should continue to provide a dividend to you regardless of what is going on with the share price.
Normally we prefer growth stocks, as their total returns tend to be better and they avoid all dividend taxes (including the nasty foreign dividend withholding tax). But during the early danger phase of your retirement, less volatile, cash flowing dividend stocks may help you to better hold onto your money.
The yield shield works by switching out your portfolio on retirement day to a portfolio that keeps a similar geographic mix to what you already have, but focusing on high-yielding dividend stocks.
After the first 5 years, you’d switch back.
In practise it could work like this. If you’re currently tracking a global stocks index with a fund like the Vanguard All-World ETF (VWRL), you could temporarily swap it out for the SPDR® S&P® Global Dividend Aristocrats ETF (GBDV).
This ETF tracks an index of top-quality dividend payers, with a weighted average yield of 4.85%, while the Vanguard All-World ETF typically yields around just 2%.
In the event of a downturn, you would in theory be ok as the 4.85% yield covers your 4% withdrawal rate, although in practise some of the companies would stop paying dividends.
This specific Dividend Aristrocrats fund though only admits companies with a 10-year track record of payouts, so you’d hope this effect would be minimal given bear markets happen more often than that, roughly every 6 years.
The yield shield means you don’t need nearly as big of a cash cushion – in theory, none at all, though we still think it’s sensible for diversification and risk reasons to hold 10% of your pot in cash regardless.
This is therefore a good alternative solution which allows you to retire on your FIRE date with your standard FIRE number and with peace of mind.
The 3% Rule
Much of the stress around retiring early could be resolved by adopting the 3% rule instead of the 4% rule.
A recent continuation study into the safe withdrawal rate extended the Trinity study period to 2017, and here’s the results:
The 4% rule for a 100% stocks portfolio still has around a 95% success rate after 30 years, now down slightly to 94%, and tails off over the decades.
But the success rate of a 3% withdrawal rate does not tail off – even after 40 years, it remains at 100%, meaning that EVERY portfolio tracking the S&P 500 since 1926 would have survived for at least 40 years.
But for us, we don’t want to be running to the safety blanket of the 3% rule.
This is because, using the MU Fire Calculator, a £1m required FIRE number becomes a £1.33m target by moving the withdrawal rate slider. And for this particular example, the years until FIRE move from 14 years at 4% to 18 years at 3%.
Could you be bothered to work an extra 4 years and build up an extra £333k if there was a smart alternative such as the cash cushion or yield shield, which meant you could retire today?
What’s your FIRE number and are you relying on the 4% rule? Check out the calculator, and join the conversation below!
Written by Ben
Featured image credit: Einstock/Shutterstock.com